ps9ans-1 - ECON 205 PRINCIPLES OF MACROECONOMICS FALL 2008...

ECON 205: PRINCIPLES OF MACROECONOMICS FALL 2008 MARK MOORE PROBLEM SET 9: SOLUTIONS 1. Consider an economy with output below potential GDP. Compare the values of consumption and investment (when output returns to potential GDP) under the following three scenarios: i) the government does nothing (so the economy adjusts on its own); ii) the fiscal authority increases government purchases sufficiently to return the economy to an equilibrium output level equal to potential GDP; iii) the fiscal authority reduces fixed taxes sufficiently to return the economy to an equilibrium output level equal to potential GDP; or iv) the central bank undertakes expansionary monetary policy of a magnitude sufficient to return the economy to an equilibrium output level equal to potential GDP. Make sure to explain the effect on interest rates in each case. Answer: We are in a recessionary gap, and are exploring mechanisms that will transport the economy to a new equilibrium in which output equals potential GDP. There are two routes: allowing the economy’s self-correcting mechanism to work (question i ), or shifting the AD curve out (questions ii, iii and iv ). We will make use of the fact that consumption increases when output increases and decreases when fixed taxes increase. 1. (i) In the recessionary gap, P < P e . Make sure you can show this on the graph. Remember that along the AS curve, Y=Y POT when P=P e . Since P < P e , if the government does nothing, P e falls, which tends to reduce the wage. As the wage falls, so does the price of goods, because labor is a large component of the cost of production. The AS curve shifts down, and continues to do so until it intersects the AD curve where Y=Y POT . Thus, real GDP (Y) rises and the price level falls. The interest rate falls as the economy moves along the AD curve (remember why the curve slopes down) and investment increases. Consumption increases (remember that consumption increases when income increases). (ii) The AD curve shifts outward and so both real GDP and the price level rise. The increase in GDP leads to an increase in demand for transactions, so the real money demand curve shifts to the right. The increase in the price level leads M s /P to fall. The effects on real money demand and real money supply lead to an increase in the

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